C R I T I C a L E V a L U a T I O N O F C a P M M O D E L |

Topics: Capital asset pricing model, Financial markets, Modern portfolio theory Pages: 9 (3216 words) Published: February 13, 2013
Table of Contents

Critical Evaluati on of CAPM Model |2

1. Introduction:
Over the years, the financial management theorists and practitioners have developed different financial management models and concepts that in turn have been facilitating the task of investment, financial and assets utilization decisions (Brigham & Houston, 1999). One such important and most widely tool that has been widely used for the portfolio management and risk assessment is Capital Asset Pricing Model (CAPM hereinafter). The model that was developed by William F. Sharp of the Rand Corporation, and the first publications regarding the model appears in 1952 that were updated in 1959 (Kuhlemeyer, 2004). Since the very introduction o the model, the financial experts in different parts of the world have been using the model and basing their decisions on the basis of the model. However, due to changes in the environmental conditions and better research in the field of financial management different models has been suggested that has a clear edge over the CAPM model (Brigham & Houston, 1999). After the publication of the French and Fama (1992) model regarding "the CAPM is wanted, Dead or Alive" most of the user think that the model has lost its significance and should be no more used for solving financial problems confronted business organizations. The CAPM model, which from the very start has remain one of the most widely contested model as different theorist and practitioners has been raising their concerns over the different shortcomings of the model (VanHorne & Wachowics, 2007). Realizing the significance of the issue, efforts will be made in this paper to critically investigate that whether the CAPM model is dead or could be still utilized for solving business problems. The paper will first explore the salient features and characteristics of the CAPM model and then list the different shortcomings

Critical Evaluati on of CAPM Model |3

of the model that has led towards the widespread criticism. The paper will then explored the different models that have been developed to replace the CAPM model and how such models have an edge over the CAPM model that has been leading towards the premise that CAPM is a dead concept.

2. Critical Evaluation of the CAPM Model:
As elaborated above the model that has been first devised in 1952 and then updated with the seminal work of John Lintener and William Sharpe in 1959, the model has served the business world for decades. The model has been developed to ascertain the risk of the different assets that the organization possess in order to determined the future net worth and investment potential of the firm (Sharpe, 1964). Essentially the CAPM model describe the risk measure that investors across the organization should agree on, possessed by the business organization and the required rate of return on an individual asset taking into consideration the risk measures of the individual asset (Sharpe, 1964). The formula for the estimation of the CAPM is as follow: CAPM = E ( RI )  R f   Rm  R f  On the other hand the Beta is equal to  

 I ,m 2 m

The estimation of Beta that is used in the CAPM model is based on lengthy time-series data gathered in the form of market return and individual asset return. By finding out the variance and covariance of individual asset the Beta could be calculated (Sharpe, 1964). In addition, instead of the procedure the Beta could also be calculated using the following regression model:

RI ,t   I   I Rm ,t   I ,t where : RI ,t  return on asset I at time t, Rm,t  return on market portfolio at time t,

 I  beta of asset I.

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In practice most of the market practitioners have been using different estimates. For example, NYSE composite index, S&P 500 index and market proxy (VanHorne & Wachowics, 2007). The CAPM model has been based on certain assumptions, for example the model assume that investor...

References: Black, F., 1972. Capital Market Equilibrium With Restricted borrowing:. Journal of Business , 45, pp.44454. Brigham, E.F. & Houston, J.F., 1999. Fundamentals of Financial Management 9th Edition. USA: South Western. Cohen, R.B., Keith, C. & Tuomo, V., 2011. How the Inflation Illusion Killed the CAPM. [Online] Available at: HYPERLINK "http://ssrn.com/abstract=548402%20" http://ssrn.com/abstract=548402%20 [Accessed Dec 2011]. Drake, P.P., 2005. Business Finance. USA: Pearson Education Ltd.. Fama, E.F. & French, K.r., 1992. Teh Cross Section of Expected Stock Returns. Journal of Finance , 47, pp.427-66. Grinold, R.C., 1993. Is beta Dead Again. Financial Analysis Journal , 49(4), pp.28-34. Hsia, C.C., Fuller, B.R. & Chen, B.Y.J., 2000. Is Beta Dead or Alive. Journal of Business Finance and Accounting, 27, pp.283-311. Jagannathan, R. & Wang, Z., 1996. Teh Conditional CAPM and the Cross Section of Expected Returns. The Journal of Finance, 1, pp.74-82. Kevin, Q. & Wang, Z., 2003. Asset Pricing with Conditioning Information: A Net Test. The Journal of Finance , 58(1), pp.161-96. Kuhlemeyer, G.A., 2004. Fundamentals of Financial Management 12 Edition. USA: Pearson Education Ltd. Ross, S., 1976. The Arbitrage Pricing Tehory of Captial Asset Pricing. Journal of Economic Theory, Dec, pp.89-101. Sharpe, W.F., 1964. Capital Asset Pricces: A Theory of Market Equilibrium under Conditions of Risk. Journal of Finance, 19, pp.425-42. Titman, S. & Wessls, R., 1988. The Determinants of Captial Structure Choice. Journal of Fianance Vol 14(1), pp.1-19. VanHorne, J.C. & Wachowics, J.M., 2007. Fundamentals of Financial Management 12th Edition. USA: Pearson Education Inc. Yoshino, J.A. & Santos, E.A.e., 2009. Is CAPM Dead or Alive in the Brazilian Equity Market. Review of Applied Economics , 5(1), pp.127-35.
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